The best way to think about risk is in terms of the probability of an investment either underperforming or resulting in a substantial loss of capital. A high-risk investment is therefore one where the chances of underperformance, or of some or all of the investment being lost, are higher than average. These investment opportunities often offer investors the potential for larger returns in exchange for accepting the associated level of risk.
Many high-risk investment opportunities fall under the classification of alternative investments, though not all, and are used to balance a portfolio and introduce assets that may have little to no market correlation.
Risk and return
One can never say that there is a direct relationship between risk and reward as the nature of risk is that there may be no reward. What can be said, however, is that there is a positive correlation between the risk and the potential for return – potential being the key modifier here. Therefore, those seeking big payouts in relatively short time periods are going to have to accept a disproportionately higher level of risk.
Unfortunately, most investors fall victim to illusory superiority and the optimism bias. These two cognitive biases combine to make us believe we will succeed where others have failed. And, when it comes to risky investments, despite all the cards being against us, we still believe we should take the risk.
Return on investment
To calculate the return on investment (ROI) you subtract your starting investment from what you ended at, and then divide by your starting position.
ROI = (Ending Position - Starting Position) / Starting Position
Broken down, you divide the gain, or in some cases loss, by the amount you started with. ROI is expressed as a percentage and can be positive or negative depending upon the end position of your investment.
As mentioned above, many high-risk investment opportunities fall under the classification of alternative investments. While the main three asset classes – stocks, bonds and cash – are often considered safe, there are a number of high-risk bonds, and smaller cap stocks, that may offer investors the potential for high returns.
A hedge fund is a managed investment fund that pools capital from a large number of investors in order to invest in a variety of different opportunities and asset classes. The term 'hedge fund' comes from the paired long and short positions that the first of these funds used to hedge market risk. Hedge funds have evolved and diversified significantly since then, using multiple complex methods to mitigate risk and to seek positive returns.
Cryptocurrencies are digital currencies that aim to operate independently of a central bank. Crypto refers to the encryption used to the transactions of the currency safe.
There are numerous cryptocurrencies in issue, though most trace their origins back to the original: Bitcoin. While there are many instances of crypto traders who have made much from the market, the markets are extremely volatile and just as many, or more, have lost significant sums.
Venture capital refers to a pooled investment fund that seeks to invest in private market companies from their early days through to their last funding round before exit (either through a trade sale, IPO, or other). Venture capital is deemed a long-term, risky investment as many of the companies backed will return little to nothing. The goal is to back one or two within a portfolio that return many times their initial investment and cover all other loses.
Venture Capital Trusts are simply publicly-listed venture capital funds that operate with a few minor additional restrictions.
Angel Investing refers to the early-stage private market investments (typically, this involves investments in startups) made by individuals investing their own money in hopes of securing significant long-term returns. Angels will often provide more than finance to the companies they invest in, opening doors to their own networks of experts, suppliers, distributors and other investors. Angels often invest as a group known as syndicates.
Spread betting is a derivative (the investor does not actually own the underlying asset they are betting on) where the investor bets that the price of that asset will either rise or fall, and then wins or loses depending on the margin by which the asset has risen or fallen against the price quoted by the bookmaker. Spread betting is one of the most speculative forms of alternative investment on the market.
A penny stock is a stock that trades at a relatively low price and has a relatively low market capitalisation. Penny stocks generally trade outside of the major stock exchanges and are considered high risk given the potential for large swings in value that may occur from larger investors buying or selling their shares and the lack of liquidity that may make it difficult to sell when desired.
A leveraged ETF, or Leveraged exchange-traded fund, is a fund that uses financial derivatives and debt to attempt to amplify the returns of an underlying index. Leveraged ETFs are available for most major indexes and segments, or sub-segments, of these indexes.
Unregulated collective investment schemes (UCIS)
UCISs are set up to allow for investment into asset classes that do not abide by the UK's Financial Conduct Authorities rules for liquidity, leverage, or cash reserves. And, while a UCIS is not directly authorised by the FCA, those that manage the scheme are themselves subject to be regulated by the FCA.